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Microsoft Has Been a Better Business Than It Has a Stock, But That Is About to Change

November 16, 2012 | About:
Currently Microsoft (MSFT) is attracting a lot of attention thanks to its launch of Windows 8 and many exciting new products based on this important upgrade. However, within all this attention there is a lot of negative bias applied to this blue-chip technology behemoth. Consequently, the goal of this article is to provide the truth about Microsoft, the company and the stock.

Much of the negative commentary spoken about Microsoft is based on the poor performance of its stock over the last decade and a half. What is unnoticed and more often than not realized is the true fact that Microsoft, the company, has been a stellar performer as an operating business over this time. However, because the price has performed so poorly, it is assumed and often declared that Microsoft, the business, has been a poor performer as well.

The Truth About Microsoft the Business

In order to get the facts straight, let’s look at Microsoft through the lens of the F.A.S.T. Graphs™ fundamentals analyzer software tool. However, with the following exercise we are going to ignore the stock price completely, and only focus on how the business has performed. Therefore, our first graph plots Microsoft’s earnings per share (the orange line) and its dividends only (the blue shaded area). The reader should note that Microsoft paid a $3.00 special dividend in 2005. When you consider that the average company in the S&P 500 only grew earnings by 6.4% per annum, Microsoft’s 12.6% per annum growth is close to double what the average company achieved.

MSFT1.png

(Click on this link or the picture above that will take you to a free, live, and fully functioning FAST Graphs™ on Microsoft.) This link will be live for 90 days starting 11/16/2012

The three dollars special dividend cited above was available due to the company’s prodigious ability to generate strong operating and free cash flow. The following graphs plot Microsoft’s operating cash flows (marked with an O) and its free cash flow (marked with an F). Clearly, Microsoft has historically generated very healthy cash flows since calendar year 1999. There are not many companies on the planet that can point to this level of cash flow generation. Once again, we see clear evidence that Microsoft, the business, has performed extremely well since 1999.

MSFT2.png

Our next graph looks at Microsoft’s yearly sales since 1999 correlated with the price to sales that the market has applied to its stock. The burgundy shaded sales paint a very clear picture of strong and consistent long-term sales growth. The blue line representing price/sales shows that Microsoft’s results have not been adequately reflected in its stock price, indicating undervaluation. However, we will focus more on this when stock price is added to the graphics later in the article.

MSFT3.png

The Truth About Microsoft The Stock

The following performance calculations on Microsoft since Dec. 31, 1998 illustrate why so many people have a negative view of Microsoft. A $1000 investment in Microsoft would have actually shrunk to only $768.89, for an average compounded loss of 1.9% per annum. Even when you add in dividends, buy and hold shareholders would have still lost money over this time period.

MSFT4.png

What we have shown so far doesn’t seem to make sense. Microsoft, the business, has clearly been a stellar performer based on fundamentals such as sales, earnings and cash flows. Additionally, their balance sheet is very strong; the company only has 12% long-term debt. This begs the question: how could such a great business produce such poor returns for shareholders? The simple, straightforward clear and undeniable answer is that overvaluation is the culprit.

Calendar year 1999 was the beginning of the end of the great technology bubble. This was a time when tech stocks were routinely being given PE ratio multiples exceeding 100 times earnings. There is no fundamental basis for this, other than an irrationally exuberant marketplace. This was a time when people were smitten with tech and willing to put insane valuations on their stocks. Microsoft is no exception.

Consequently, you will notice that Microsoft’s stock price went nowhere but down for several years even though the business was growing. Above-average growth led to below-average returns simply because the market had been grossly mispricing technology shares. It’s important to recognize that the management of any company can only control their operating results. The management of the company cannot control what price the market applies to those results. In other words, Microsoft did not deserve the high valuations of the late 90s, and we’re arguing here that they do not deserve the low valuations today.

MSFT5.png

The following estimated earnings and return calculator shows that 32 analysts reporting to Standard & Poor’s Capital IQ expect Microsoft to grow earnings at 10% per annum on average over the next five years. This does not seem implausible when you consider that the company has grown earnings at over 12% for the last 15 years, as you will see in a moment for over 12% a year since the great recession of 2008. We believe Microsoft should rightfully be valued at least 15 times earnings based on its recent history and reasonable expectations of future earnings growth.

MSFT6.png

This next graph simply shows that Microsoft has averaged 12.4% since calendar year 2008. In other words, as previously stated, it certainly validates the possibility of a 10% forecast.

MSFT7.png

Summary and Conclusions

Buying low in order to sell high is the cornerstone principle of sound and prudent investing strategy. Yet ironically, it seems that many investors find it very difficult to buy when stocks are reasonable and somehow easier to buy them when they’re expensive. We believe the graphics shown in this article clearly illustrate this phenomenon. When quality tech stocks like Microsoft were insanely overvalued, you couldn’t beat investors off with a stick. Today, when Microsoft shares can be purchased at a significant discount to fair value offering a dividend yield that has grown every year for 10 consecutive years (Microsoft is a Dividend Contender on David Fish’s lists), nobody seems interested.

Microsoft certainly has its antagonists; however, we believe most of those antagonists are basing their judgments on the company’s historical price performance. Because, as we have clearly illustrated with this article, Microsoft, the business, has been a stellar performer. It is only because the stock was so in credibly overvalued a decade and a half ago that investor shareholders received such poor returns. We believe that the opposite circumstances exist today for the stock; however, the prospects for the business remain intact. Therefore, we believe Microsoft represents a compelling opportunity to invest in a high-quality blue-chip dividend growth stock at a very low valuation.

Disclosure: Long MSFT at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment adviser as to the suitability of such investments for his specific situation.

About the author:

Chuck Carnevale
Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm. He has been working in the securities industry since 1970: he has been a partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

Visit Chuck Carnevale's Website


Rating: 4.2/5 (30 votes)

Comments

BEL-AIR
BEL-AIR - 2 years ago
Chuck you are a legend man, thank for the great article, you nailed it exactly with MSFT...

I been watching it for months now, hoping praying it will hit my buy point.

If there is a small correction in the market and one could buy MSFT for lets say $23, it would be cheaper than even the bottom of the 2009 crash, and the cheapest it's been in decades at that price and no matter how you value the business against, book value, pe, cash flow, pre tax earnings, owner earnings etc.

Heck even at the current price it is a good deal, but I am cheap so I gonna wait.

It is on my Christmas list, maybe I can buy it like a boxing day sale, it would make me to to happy.

Plus they been buying back shares like crazy, all good news for the part business owners in this fine business.

I am hoping windows 8 can get some bad news or reviews to push it down more so I can buy.

Keep up the good articles chuck, they are world class.

sifton
Sifton - 2 years ago
I agree with all you have said in this article,and have thought of adding to my portfolio,however Gates continues to sell millions of shares every quarter.Do you think I am making to much of this?

superguru
Superguru - 2 years ago
Chuck - I agree with what you wrote.

Reason I am bearish on MSFT is because they missed the whole mobile and internet and tablet markets. They have always lacked innovation but they know how to sell to CIOs of corporations.

also atleast in US. It uncool to be seen with a Windows laptop. I mean I meet people for work who carry windows laptop and first thing they say appologitically- oh my company gave this windows laptop to me but at home I use mac. As soon as my company starts giving macs I am going to change my useless windows with mac book pro.

MSFT will always be great business but consumer has better choices now. And consumers will force the corporations sooner or later to adopt the better choices.

Also I have elementary school kids and they are all apple at home and at school. They hate anything MSFT.
shaved_head_and_balls
Shaved_head_and_balls - 2 years ago
I hope Microsoft has better luck than the computer company Hewlett Packard. In 2010 many investment advisors, including the author of this article, promoted HP as an undervalued high quality stock. HP is down over 70% since then, while the market is up roughly 30%. Proving once again that it's impossible to predict the future of stocks in the computer industry based on simplistic valuation metrics and graphs.

Microsoft lovers better hope that the corporate world doesn't accelerate adoption of the Google, Apple, and Linux operating systems, or Microsoft will be a slow-motion rerun of the Hewlett Packard train wreck.

Lately Microsoft is usually chasing trends and very late to the party, which is a shame because some of their new products are pretty well-designed.

AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Imagine if Coca Cola had repeated the New Coke exercise over and over again - that's MSFT.

Disclosure: Long Apple, Long MSFT (by 5X Apple). :-(
chuckc
Chuckc - 2 years ago


BEL-AIR,

Thanks for the kind words.

Chuck

chuckc
Chuckc - 2 years ago
Sifton,

In a word yes. Gates is making personal financial decisions, not a rejection of MSFT. IMHO.

Chuck
chuckc
Chuckc - 2 years ago
Superguru,

You have a point, and MAC was a bright spot for AAPL, however, it is a big market and MSFT has a hugh base.

Chuck
chuckc
Chuckc - 2 years ago
Shaved_head_and_balls,

Thanks for sharing your perspective. However, I feel you are failing to make the distinction between the stock and the company which was the intent of this article. IMHO, HPQ remains a significantly undervalued tech. Current profits warrant a much higher price. Remember, Mr. Market was pricing tech at multiples above 100-150 times earnings and higher in 1999-2000 before reality set in.

Fortunately for me, I am a long term investor. Therefore, I am patient to wait out market foolishness. Thanks again for offering your views.



Chuck



chuckc
Chuckc - 2 years ago


AlbertaSunwapta,

Thanks for sharing that interesting perspective. Hopefully, Windows8 is the old coke.

Chuck

vuasu
Vuasu - 2 years ago
In the corporate world, it is very hard to work on Apple products all day long. And the IT folks will stay with what they are trained in...Microsoft and Unix products...
vuasu
Vuasu - 2 years ago
Windows 7 are just beginning to come into corporations...many are still running Win XP.
Melcome
Melcome - 2 years ago


1. Apple products are appealing as a Mercedez benz. A premium product, expensive to own but that is essentially a dominant factor in its appeal. They make amazing consumption products(play videos, surf the web, many many applications) which translates to a "loyal fanbase". Think about this... would Apple have garnered so much respect and "awe" if they priced Apple products as cheap as Dell's?

However, that doesn't translate into stealing marketshare for PC purposes in every target audience.

Most are deeply ingrained businesses processes which have consumers who are "working at their jobs" and who have NO desire to invest more effort into their jobs(most people do not enjoy going to work!).

Thus, most of these people will probably not be eager to invest massive amounts of time into learning new softwares, Operating systems for the sole purpose of employment. (nore will their business owners spend huge amounts of money on training, time wasted just to adjust).

In contrast, when used for pure pleasure and consumption, the evidence is conclusively showing that even the less wealthy are attracted to Apple's branding(rich design, luxury item, expensive).

But you will notice, that most of the people attracted to the product for those reasons(which is Apple's main target market) are buying NOT on their APPEAL FOR WORK PURPOSES. In fact, they could have simply gotten a Windows product to accomplish that work. This shows that Apple's impressive growth has not been DIRECTLY attributable to this crowd(they have indirectly enjoyed converting many though). I will concede, we have also seen evidence that growth in sales has come from the less wealthy segments of the population, such as students.

However, why do they buy it? Again, not for much except: opening spreadsheets, documents and tons of "leasurely" applications. Something Microsoft Windows can already do.

Now, Why am I saying all of this?

1. Will everyone ENJOY apple products?

2. Does Apple's impenetrable moat(apps on Iphone) translate to COMPUTERS?

THE MAIN ERROR

In my opinion, the public's view is misguided in assessing MSFT's as an Investment.

They assume that it is doomed to fail in the PC segment because

Apple has been stealing market share due to its impressive moat(tons of apps).

What is completely overlooked and leads to unwise conclusions is that those appealing factors automatically translate into MSFT's target audience for PCs.

They mistakenly generalize Apple's strength in the MOBILE segment for the PCs/Laptops FOR ALL USERS.

MSFT:

1. offers a choice for those who do not buy a PC for the reasons mentionned previously.

2. Taking these facts into account, Microsoft has never tried to target Windows to the wealthy in the past.

3. Today, MSFT strategy is clearly trying to shift to the consumers mentionned above(fanboys of luxury, expensive products). Probably to ease the pressure of losing market share because I don't believe they can win THIS fight.

However, dont forget

#1 :they forget: Microsoft doesnt currently appeal or targeted the same kind of audience as Apple for ITS PCs!! (It allowed PC manufacturer's to compete, thus creating relatively inexpensive products).

#2 The "foreseen" failure may be justified(I will admit) if it were ONLY about MOBILE PHONES!

Apple's got an impressive moat there with TONS of miscellaneous applications!

Nevertheless, do major lines of business rely upon consumption applications such as Itunes? Imaps? etc? I don't think so.

c) For businesses, the COST + Inconveniences will certainly be Main drivers in their decisions for purposes of advanced software/infrastructure development.

d) Microsoft's resistance in being 100% vertically integrated is allowing them to INDIRECTLY offer cheaper PC's! You'll notice that for 50-60% of an apple product's price, you can get a PC that is JUST as powerful.

e) There are users who NEED the alternative: Windows PCs.

I'll name one, which is an important consumer who can't work on Tablets nore Mobile phones.

Hardcore Gamers :

1.Games are constantly more demanding and you have to upgrade constantly.

2. They will continue to buy computer's to pay up a reasonable price for a gaming PC; in contrast, they would have to shell out more cash for an Apple product.

3. these users, could get a computer that is insanely stronger.

(they do not care if they play World Of Warcraft on an Apple or not, as long as they get the best performance for their money.... besides they will have to shell out another PC very soon maybe every expansion).

4. It is a known fact, most blockbuster titles are coming out on windows and hardcore gamers are stuck if they are on Apple products. (example: Guildwars2 did not have MAC until recently).

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